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We recommend a buy rating on Baidu Inc. (NASDAQ:BIDU). Revenue increased by 76% from a quarter a year ago and the company managed to gain more market share (72.8%) especially after Google Inc’s withdraw from the Chinese search market. With more Chinese users plugging into the World Wide Web and Baidu Inc’s introduction of new products, we expect the company to further increase market share and enhance profitability.

Strong earnings growth and financial position

Baidu Inc. Q3 2010 results indicate that, on a quarter-by-quarter basis, revenues increased by 76%, gross profit increased by 101% and net income increased by 112%. The company is also guiding for further increases in revenues for Q4 2010.

Dominance of the Chinese Internet Search Market

Baidu Inc. (NASDAQ:BIDU) managed to increase its market share to 72.8% especially after Google Inc. withdrawal from the Chinese market. This market share is expected to grow as more Chinese users plug into the World Wide Web. Currently, 31.6% of the Chinese population uses the interest. This number is expected to grow as more Chinese citizens shift to production and manufacturing jobs.

Growth Prospect

Baidu Inc. (NASDAQ:BIDU) commitment to the introduction of new products suggests that the company got more opportunities for further growth. For example, the new “Box Computing” product from Baidu Inc. should enhance profitability from online marketing.

Baidu.com Inc. (NASDAQ:BIDU) Key Financial Data

BUY rating

1. Strong Earnings Growth and Financial Position

Third quarter results for 2010 show strong revenues and earnings growth as compared to the same period last year. Revenues increased by 76% from a quarter a year ago to RMB 2,255.86 millions. Gross profit and net income increased by 101% and 112% from a quarter a year ago to RMB 1,682.29 and 1,046.65 millions, respectively.

Comparing gross profit margin between Baidu Inc (NASDAQ:BIDU), Sina Corp. (NASDAQ: SINA) and Sohu.com Inc. (NASDAQ: SOHU) reveals that Baidu’s sales contribution to earning has decreased since 2006. Gross profit margin decreased from 70% in 2006 to 64% in 2009. It appears that there is a dramatic increase in cost of revenues in 2008 and 2009.

Baidu Inc. (NASDAQ:BIDU) cash position shows strong cash from operations from 2006 to 2009. In 2009, cash from operations increased by 417% as compared to 2006. The company is also making capital investments, though lower in 2009, which should increase future return on investments. Free cash flows are positive and on the rise since 2006. This suggests that the company is generating enough cash even after making capital expenditures which leaves more room for expansions and new product development.

Free Cash Flows, Baidu Inc. (NASDAQ:BIDU)

2. Dominance of the Chinese Internet Search Market

Baidu Inc. (NASDAQ:BIDU) managed to gain market share from rival Google Inc. (NASDAQ:GOOG) after its withdrawal from the Chinese market. Currently, Baidu Inc. (NASDAQ:BIDU) maintains a 72.8% market share based on Internet search revenue. This market share represents an increase of 2.5% from 71% in the last quarter. On the other hand, Google Inc. (NASDAQ:GOOG) slipped to 24.6% from 26.8%.

Market Share based on Total Revenues

Baidu Inc. (NASDAQ:BIDU) maintains its dominance over the Chinese Internet search market by tailoring to the specific needs of Chinese citizens. For example, Baidu Inc. search engine allows for Chinese language character search with the possibility of predicting the search term. This comes handy as typing Chinese language characters can be relatively difficult.

Analysis of Baidu Inc. (NASDAQ: BIDU) balance sheet as of 30/09/2010 shows robust performance as compared to the same period a year ago. Current ratio, debt to asset ratio and debt to equity ratio remained relatively unchanged, which highlights the sound financial position of Baidu Inc. (NASDAQ:BIDU). The company also pods well relative to Chinese competitor Sohu.com Inc. (NASDAQ: SOHU) in terms of financial strength.

Comparing Baidu Inc. (NASDAQ:BIDU) to Google Inc. (NASDAQ:GOOG) based on liquidity shows that the Mountain View California based company has a great advantage over Baidu. That is expected since Google is more of a global company while Baidu is mainly focused on the Chinese and Japanese markets. Current ratio, debt to asset ratio and debt to equity ratio all show that, in terms of liquidity, Google Inc. (NASDAQ:GOOG) is doing relatively better as compared to Baidu Inc. (NASDAQ:BIDU). The following three charts show the comparison based on recent results and a quarter a year ago.

Current Ratio Comparison

Debt to Asset Ratio Comparison

The story is similar when it comes to operating cash flows and free cash flows. On both measures, Google Inc. (NASDAQ:GOOG) enjoys a better cash flows position when compared to Baidu Inc. (NASDAQ:BIDU). The following two charts show the comparison based on current earnings releases and a quarter a year ago.

Operating Cash Flows Comparison

Free Cash Flow Comparison

However, in terms of valuation, Baidu Inc. (NASDAQ:BIDU) is trading at a higher P/E ratio as compared to Google Inc. (NASDAQ:GOOG). Baidu is trading at an impressive P/E ratio of 90 while Google is trading at a P/E ratio of 23.94. This is indicative of the high growth potential for Baidu especially after Google existed the Chinese market.

Baidu Inc and Google Inc Stock Performance

3. Growth Prospect

Baidu Inc.’s commitment to introduce new products to accommodate raising demand for the Internet in the Chinese market suggests that the company have more room to grow. Currently, the percentage of Chinese Internet users out of the total population is around 31.6%. With that number expected to grow and Baidu Inc. (NASDAQ:BIDU) being a top player in the Internet search industry, we expect the company to grow further and expand its market share.

Although Baidu Inc. (NASDAQ:BIDU) growth potential in the Chinese market is promising; there are two things to watch out for. In a recent interview with Robin Li, CEO of Baidu Inc., he stated that the cost of censorship required by the Chinese government is costly. The cost of censorship is two folds; one is the actual cost of abiding by the rules of the local government and the other is the relative limitation of growth. Censorship might prevent Baidu Inc. (NASDAQ:BIDU) from pursing opportunities that are against the rules set by the Chinese government.

The other potential threat to Baidu Inc. is the possibility of government intervention to regulate the industry. It is unlikely that the government will allow Baidu Inc. to be the dominant player in the industry. For example, Xinhua, the state run media agency, formed a joint venture with China Mobile (NYSE:CHL) to establish a new Internet search engine. More regulation of the Internet search industry might reduce future profitability of Baidu Inc. (NASDAQ:BIDU).

Analyst Certification

I, Munther Albusaidi, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.

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